Is Ma Bell Looking Sexy?

NEW YORKERS KNOW that the best way to avoid earthbound pigeon droppings is to look down, not up. Don't walk over heavily spotted sidewalk sections, and you'll avoid walking under the beaked bombers' favorite roosts.

Value investors can benefit from the opposite advice — look up, not down, to reduce the frequency of portfolio splatterings. While most Wall Street pros focus on earnings, which appear at the bottom of companies' income statements, the most useful information may be that at the very top: sales.

James O'Shaugnessy, author of "What Works on Wall Street," believes sales are a better predictor of stock performance than earnings. He made his case using 43 years' worth of data to show that stocks with low price/sales ratios had outperformed those with low price/earnings ratios. And stocks that had both low P/S ratios and sales momentum gained 18.4% annually over the 43-year period, far better than the broader market's 13.0%.

There are a few possible explanations for this. Since sales appear on the top line of the income statement, before a company's accountants have had their say, they're less likely than earnings to be the subject of mistakes or misdeeds. Also, sudden business expansions often show up as revenues long before they translate into profits. But perhaps the main reason sales-based value investing works is that, since it looks "up" while most investors are looking "down," it turns up companies that are out of most investors' minds. And thus a bit cheaper.

Our Price/Sales screen is a great way to improve the chances that profits (and nothing else) fall your way. You can run it yourself anytime — it's one of 21 screens pre-loaded into our stock-screening tool.

We recently performed the search ourselves, sifting through 8,300 stocks for those with price/sales ratios below 1.0 (meaning annual sales are greater than market cap) and in the bottom quartile for their respective industry. And sales growth had to have topped 15% annually on average over the past three years. We then looked for positive net margins and price/earnings-growth, or PEG, ratios below 1.0. For a list of all our criteria, see the recipe on the right. Our search turned up 14 names, including AT&T Corp (T).

OK, we see you're upset with us already. Like many investors, you may have nibbled in recent years on AT&T's tantalizingly cheap shares, only to end up with a sour stomach. A look at the chart shows it's down 33% in the past 52 weeks. Extend the chart out five years and...on second thought, don't. The stock is down 78%.

Rest assured, we're not going to turn the lights down low and play Barry White's "Honey Please, Can't Ya See" while we sweet talk you on the Bedminster, N.J.-based phone company's prospects. Instead, we'll leave the lights where they are and opt for the far more sincere "I've Got So Much to Give", because while half of the company may well atrophy out of existence during the next five years, the other half makes the stock seem to be a bargain right now.

There are still a lot of parts to Ma Bell, but we can broadly lump them into consumer services, which will likely bring in $9.5 billion in 2003, about 27% of the company's revenues and down 17% year-over-year, and business services, which will account for the rest (about $25 billion in sales, down 4% this year). The fact that both sides of the company will shrink this year doesn't seem to bode well. But the good news is that one of them is going to recover nicely in coming years. It won't be the consumer side.

Long-distance phone service has suffered the biggest losses in the consumer division. Analysts figure the unit will bring in sales of $7.3 billion this year, down from $14.4 billion in 2001 and $10.2 billion in 2002. As more regional phone companies gain approval to offer long-distance service, the losses will continue, says Lehman Brothers analyst Dale Lynch. He figures long-distance sales for AT&T will amount to just $500 million by 2010.

The result for investors, though, might not be as bad as it sounds. "While nothing is likely to reverse this long-term revenue decline, two things can mute the impact on cash flows: 1) slowing the rate of decline due to customer defections and 2) driving costs out of the business," wrote Lynch in a Nov. 11 research note. "We believe the cash flow within consumer services will remain positive through at least 2008, and perhaps longer." (Lynch doesn't own shares of AT&T; Lehman has an investment-banking relationship with the company.)

Even when long-distance cash flow turns negative, the company figures the loss will be less than consumer services contributes to the business side in cost subsidies through the use of its network. And bundled voice services, the other $2 billion of AT&T's consumer business in 2003, should be able to increase revenues to just under $5 billion by 2010. So the consumer group won't be a total bust.

The news from business services is better. AT&T is already the market leader in enterprise services, with a 15.8% share, compared with No. 2 SBC's (SBC) 13.1% share. Analysts say business-service revenue should increase by about 2.5% annually through 2010, when it will top $30 billion.

That's not stellar sales growth, granted. But the key is margins. Lynch divides the company into "drag" segments and growth segments. As the former shrinks 4.5% annually through 2010 and the latter grows 3.5%, the results will be total revenue growth of just 0.4% per year. But thanks to a shift from less profitable businesses to more profitable ones, Ebitda (earnings before interest, taxes, depreciation and amortization) during the period will increase by 1.4% per year. Lynch projects that a debt pay-down to $8.7 billion from $15.3 billion now, along with slower growth in capital expenditures, will parlay the results into operating income growth of 5.7% annually and earnings growth of 10%.

With so many moving parts, AT&T isn't an easy company to figure out. But on a price/sales basis, the story is simpler. AT&T is a 0.43; the communications-services industry is a 1.15.

Shares trade at just 8.1 times Reuters Research's 28-analyst consensus of $2.38 in 2003 earnings, compared with the group's P/E of 13.5. Since analysts, on average, say AT&T will increase earnings by 9.4% annually over the next five years (including a dip to $1.69 in 2004), a touch faster than peers' 9.0%, the stock's PEG is 0.9, cheaper than either the group's 1.5 or the S&P 500's 1.7.

That's it for the sweet-talking. We suggest you take a hard look at shares for yourselves, and see if any chemistry develops. One last thing to consider: investors who do take a chance on love with AT&T will be slow-dancing with a 5% dividend yield.

For the rest of our Price/Sales survivors, click here.